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The case for short selling

This article first appeared in the St. Louis Beacon: September 26, 2008 - From famous CEOs like John Mack of Morgan Stanley to infamous CEOs like Kenneth Lay of Enron, short-sellers have been blamed for major flops in companies' stocks.

Critics of short selling -- the betting that stocks will fall -- have called these investors anything from anti-American to financial terrorists to vultures. The critics are often CEOs whose stocks are being battered, but many experts say responsible short-selling is not only a time-honored financial tactic but also a necessary one.

"On average, short sellers are important contributors to efficient stock prices," says a study in the April issue of the Journal of Finance, which tracked short-selling on the New York Stock Exchange between 2000 and 2004.

"Ninety-eight percent of shorting is perfectly legitimate and OK," says John J. "Joe" Terril, who runs an independent investment advisory firm in St. Louis. "It's just like 99 percent of the time when someone uses a knife, it's for a legitimate reason, like cutting bread."

Responsible short-selling -- rather than rumor-mongering and blatant attempts at manipulating stocks -- enables investors to get a fuller picture of a company's valuation, says Michael J. Alderson, professor of finance at St. Louis University's John Cook School of Business.

"People who short stocks are part of the financial ecosystem," says Alderson. "CEOs would like to see these 'predators' removed from the ecosystem." CEOs view short-sellers with the same contempt as they do analysts issuing sell recommendations, he adds.

Short-selling has produced more than its usual share of headlines during the current economic crisis.

Executives from Bear Stearns (which was acquired by J.P. Morgan Chase), Lehman Brothers (which filed for bankruptcy) and Morgan Stanley (which plans to sell a 20 percent stake to a Japanese banking colossus) complained that short-sellers were trashing their companies.

"It's very clear to me [that] we're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down," Morgan Stanley's John Mack told employees in a Sept. 17 memo. "You should know that the management committee and I are taking every step possible to stop this irresponsible action in the market."

Two days later, the Securities and Exchange Commission ordered an immediate ban on the short-selling of 799 financial stocks that included banking giants, such as Wachovia; several St. Louis companies, such as Stifel Financial; and several Kansas City-based companies, such as UMB Financial.

CRISIS MANAGEMENT

The short-selling ban is only a small part of the federal government's efforts to stabilize the economy. Treasury Secretary Henry Paulson's $700 billion economic recovery plan is the centerpiece, and Monday the House is expected to vote on it. 

The recovery plan will take years to complete; but the short-selling ban will remain in effect until the bailout plan is passed -- but no later than Oct. 17. The SEC, which had said it may extend the ban "if it deems an extension necessary in the public interest and for the protection of investors," extended the ban after its original Oct. 2 deadlne.

"This action ... would not be necessary in a well-functioning market," said SEC Chairman Christopher Cox in imposing the ban. "Under normal conditions," legitimate short-selling "contributes to price efficiency and adds liquidity to the markets."

The ban was enacted because "unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation," Cox added. "Financial institutions are particularly vulnerable to this crisis of confidence and panic selling."

Although CEOs undoubtedly would love to keep the ban for a long time, financial experts dislike such restrictions.

"Yes, there are some slimy folks out there who short stocks and spread rumors, and the SEC should go after these people," says Matthew Warren, associate director of equity research at Morningstar, the independent financial research firm. In fact, the SEC said in mid-July that it would examine trading activities to determine who was trying to manipulate stock prices through false information.

This review will "provide an opportunity to double-check that broker-dealers and investment advisers have appropriate training for their employees and sturdy controls in place to prevent intentionally false information from harming investors," the SEC said.

Warren, who doesn't like the idea of any ban, says short-selling is "healthy" and necessary.

"Skeptics are able to add to the public discourse about the valuation of the companies," he says. A prolonged ban "would make for a less efficient market and could make stocks overvalued."

THE GOOD, THE BAD, THE NAKED

Short-selling reverses the standard concept that you make money if your stock goes up and loses money if it falls below your purchase price, says Marshall Blume, professor of finance at the Wharton School at the University of Pennsylvania, in a recent interview on the school's website.

He uses the following example: Let's assume an investor believes a $50 stock is overvalued and will fall to $40. The investor borrows the stock from someone else and then sells it for $50. When the stock price falls to, say, $40, Blume adds, the investor buys the lower-price stock and then returns the original-price stock to the lender. If the price falls to his expected target, the investor earns $10 because he bought the stock at $40 while selling the borrowed shares at $50.

Legitimate shorting can shed light on bad balance sheets as well as inflated stocks. For example, investors who shorted Enron's stock benefitted from research that revealed the massive financial rot in the now-defunct energy company.

On the other hand, stocks can be rattled by loudmouth hedge-fund managers who gang up on a company, make inflammatory comments and peddle rumors to the public and financial advisers.

Abusive short selling "is like yelling fire in a crowded theater," says Morningstar's Warren.

And then, there's naked shorting. Although traditional shorting involves selling a stock that an investor has borrowed, "a naked short means that I sell a stock and I don't borrow it first," says Wharton's Blume.

"Now, if I do this within a day, there's no real problem because I short the stock and then I buy it back ... so I never have to deliver the stock," Blume says.

Naked shorting infuriates CEOs more than traditional shorting. The SEC issued an order on July 15 on naked shorting requiring that short-sellers must borrow shares of 19 financial giants. The regulation lasted until Aug. 15.

However, the value of such a ban was challenged in preliminary findings of a study by a finance professor at Switzerland's International Institute for Management Development. "While short selling has increased overall, short selling activities in the 19 stocks have not increased significantly more than in comparable U.S. financial stocks," the study says.

The research concludes that the negative returns on the 19 stocks "cannot be attributed to short-selling activities" and that these stocks' lower market value "is not caused by short-selling activities."

Meanwhile, the SEC's September shorting-ban already has undergone revisions. The SEC has added companies -- on a daily basis -- to its do-not-short list; and it has made several changes to allow shorting as part of certain traditional practices.

All of the attempts to impose temporary fixes -- as well as to fix theses fixes -- have reinforced the belief among financial experts that the widespread ban should be lifted as soon as markets stabilize.

St. Louis investment advisor Joe Terril likened the SEC's short-sale ban to declaring martial law during a hurricane, a necessary action during turbulence that should be withdrawn as soon as possible. The ban, he says, shouldn't go beyond 90 days.

"If you can't restore confidence to credit markets in the next 90 days," Terril says, "we're going to have a massive problem."

Robert W. Steyer, a freelance journalist in New York, writes about business. 

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